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Saturday, March 22, 2014

The Impossible Trinity and the Tapering

The Impossible Trinity is an economic theory that states that a country can only control two of the following three levers: Exchange Rate, Free Capital Movement and Monetary Policy.

The recent Emerging Markets Crisis is a real world manifestation of this theory.

Countries in ASEAN often chose to control their exchange rate and free capital movement thereby allowing US interest rate to dictate our domestic interest rate.

This has created stock market and property bubbles in this part of the world and the recent tapering by the US Fed is causing these bubbles to deflate.

It is not easy for so-called Emerging Markets to actually emerge to become developed countries.

Economics can explain the recent events surrounding the demise of the global emerging markets where countries with weak current account deficits face fund withdrawals and see their currencies crashed and burned. This theory that has caught my fancy some time back is worth mentioning today. It goes by a fanciful name: the Impossible Trinity. The Trinity - as in the female lead in The Matrix. Well... never mind. The theory states that a country can at one time only control two out of the following three economic levers:

1. Exchange Rate

2. Free Capital Movement

3. Monetary Policy (Interest Rate)

It is a futile effort to try to control all three at the same time as dictated by another "chimmer" (more difficult) theory called the uncovered interest rate parity which I have no idea what's it really about but it doesn't really matter. Today, it's about Trinity and the Matrix. Let's go through an example to see how deep the rabbit hole goes see this clearer. We shall use Singapore, our beloved motherland.

Singapore controls exchange rate and enjoys free capital movement. Long ago it was determined that Singapore's small economy would be subjected to the global economic forces and it made more sense for us to control our exchange rate rather than our domestic interest rate. By having control of our exchange rate, we can make our exports competitive and we can also curb hot money flows and tame inflation. This meant that we then gave up control of our monetary policy ie domestic interest rate. Singapore's monetary policy is then, and still is, dictated by our trading partners which are the world's biggest economies and needless to say, the US monetary policy matters the most.

Ok let's now go into the specifics. Are you ready to take the red pill?

Say, Singapore wants to also control its monetary policy. We think that our red-hot property market is too hot. We need the final cool down bazooka measure. Raise interest rates. The impossible trinity states that this cannot be done.

When we raise the domestic interest rate, traders will want to invest in our SGD because it would be more attractive than that of our trading partners. Free capital movement means that hot money would flow into SGD, causing the SGD to appreciate. But at the same time, we want to control our exchange rate. So MAS, the Monetary Authority of Singapore, our central bank, would sell SGD to try to bring the exchange rate to where we want to be. This causes the base money supply of SGD to increase. When money supply increase, the price of borrowing goes down, thereby reducing the interest rate that we wanted to raise in the first place. Back to square one.

Conversely, say Singapore's property market has crashed and burned, led by the skyfall of Sky Habitat in Bishan. If we now want to lower interest rate to help give our property market a boost, again free capital movement allows hot money to leave the country (since lower interest rate meant that hot money should flow to other countries with higher interest rates) thereby causing the SGD to weaken. But we also wanted to maintain exchange rate remember? We want to have the cake and eat it! Not forgetting the cherry as well! So now, MAS needs to use reserves to defend currency ie buy up SGD in the forex market. This reduces the base money supply of SGD dollars which ultimately forces interest rate to go up. And this defeats the original purpose of us wanting to lower interest rate in the first place.

It's the most intriguing economic trilemma!

The origin of the recent crisis in the emerging markets has a lot to do with this. Although it was triggered by different mechanisms: namely tapering and current account deficits.

Most Asian economies have similar models as laid out by the Impossible Trinity in the sense that we allow our monetary policies to be dictated by the US. We just tried to control the other two levers: fix the exchange rate and allow free capital movement. In order to contain the Global Financial Crisis (a.k.a. the GFC), Alan Greenspan, Ben Bernanke and now Janet Yellen allowed the interest rate in the US to be lowered to zero. When that was not enough, they printed money. Lots and lots of money. It's like trillions of dollars annually, that's bigger than a lot of Asian economies - combined.

It was like opening a tap and just let the liquidity run. The faster the better. All the money/liquidity gushing out had to go somewhere. Anywhere!

Remember that we (as in most Asian countries) fixed our exchange rate? Well we fixed it too low in order to make our economies competitive, the excuse was to allow our exports to sell in the global market. Chinese cheap goods, Thai made cars, Singapore made hard disk drives (well we used to make them before Flash memory came along), Korean gadgets etc. So all these money fled from the US, and from Europe to be parked in Asia. In our stock markets, our private properties and our banks. Yes that's how Sky Habitat soared!

This created the Asian boom from 2009 to 2013 as we saw most Asian stock markets hit highs. But as the US economy recovers, the need to maintain the liquidity tap on diminished. So US talked about tapering. It was a big thing! Tapering wasn't about turning the tap tight and off. It was just like hey let's just twist in by a little, just a little, so that the liquidity gush becomes, well, less of a gush. After all, in Singapore, we are always taught to save water. Now, most public taps don't even allow you to turn it. It's all sensor controlled!

A typical tap in Singapore's public toilets

What happened when the US hinted about tapering? Markets from India to Indonesia crashed. Now it's Argentina, Turkey and the other Fragile Five. China had its own truckload of problems. Man, Tapering became the new Agent Smith (the biggest villian)! And Asians the poor victims... Of course, not all victims are created equal.

Countries with current account deficits got hit very hard. Basically these are countries that import more than they export. So with tapering, money flows out, their currencies weaken, further exacerbating the current account deficits which could result in a vicious spiral that they cannot get out. In short, weak currencies leads to bigger deficits which leads to even weaker currencies. Crash and burn! This is not unlike the Asian Financial Crisis in 1997 when some of the currencies declined 70-90% vs the USD, never able to recover since then.

In the end, emerging countries have seldom proven if they could really emerge. Most don't. Even China is having a tough time trying to catch up with the rest of the developed world. It's still much easier to stick to investing in global names with proven track records.

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